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50,000 50,000 Capital, Bill 25,000 50,000 Total liabilities & capital $475,000 $500,000

      The initial tax balance sheet indicates that Lisa contributed $50,000 toward the tax basis (remaining cost) of the partnership's assets, and Bill contributed $25,000 of this amount. Yet, as indicated on the book balance sheet, Lisa and Bill would each be entitled to receive $50,000 if the partnership were to liquidate. Now assume that in its first year of operations, the partnership earns net income (book and tax) of $120,000 and distributes $40,000 of this amount to Lisa and Bill ($20,000 each). Assuming no change in debt, the partnership's balance sheets would now have the following balances:

		Section 704(b)
	Tax	Book
Total assets	$555,000	$580,000
Mortgage, Building	$400,000	$400,000
Capital, Lisa	90,000	90,000
Capital, Bill	65,000	90,000
Total liabilities & capital	$555,000	$580,000

As illustrated, Lisa and Bill's capital accounts would each be increased by $40,000 on both balance sheets ($60,000 share of partnership net income, less $20,000 distribution received). Therefore, Lisa's $90,000 capital balance on the tax basis balance sheet reflects her total direct investments in the partnership of $50,000 at formation plus her $40,000 of reinvested profits. Bill's capital account on the tax basis balance sheet reflects the $25,000 basis of the land initially contributed to the partnership, plus $40,000 of reinvested profits. The book balance sheet, in contrast, indicates that if the partnership were to sell all its assets at their $580,000 year-end book value, each partner would receive $90,000, after payment of the partnership's creditors. This balance sheet reflects the partners' legal and economic rights to partnership assets, which are based on the fair market values of the properties each contributed (as of the date of contribution), adjusted for additional investments (reinvested profits) and distributions made since that time.

      Therefore, the partner capital accounts play a crucial role in determining the consequences for the partners of partnership activities. Because a partner's share of partnership income is credited to his or her capital account, therefore giving him or her a right to withdrawal of a like amount, he or she is taxable on that income even if it is not currently distributed by the partnership. Any income not withdrawn remains in the partner's capital account, and constitutes an additional investment by the partner in the partnership. The partner's basis in the partnership interest is increased to reflect this additional investment. Finally, because the partner retains the right to withdraw his or her capital, including reinvested earnings, from the partnership in the future, his or her interest in partnership assets, as reflected on the book balance sheet, is also increased by any portion of that share of earnings which is not withdrawn (that is, received as a distribution) in the current year.

      Knowledge check

      1 Dale and Roy formed a partnership early this year. Dale contributed $150,000 cash in exchange for a 50% interest in the partnership. Roy contributed land with a tax basis of $90,000, and a fair market value of $150,000 in exchange for the remaining 50% interest in the partnership. What will be the balance in Roy's book capital account in the partnership's balance sheet?$150,000.$90,000.$60,000.$75,000.

      Self-employment tax issues

Generally speaking, a significant disadvantage of the partnership form relative to the S corporation form is the self-employment tax. A shareholder's share of pass-through income from an S corporation is generally not treated as earned income,¹³ and therefore does not trigger self-employment (SE) taxes; in contrast, a general partner's share of ordinary income (but not capital gains, interest income, and the like) from a partnership is subject to self-employment tax.

Different rules apply to limited partners. Because limited partners are not allowed to participate in management, their shares of partnership income are not classified as earned income and therefore do not trigger self-employment tax.¹⁴ This provision does not apply to guaranteed payments received in exchange for services rendered to or on behalf of the partnership.

      For this reason, it is not uncommon for some general partners to structure a portion of their interest in a limited partnership as a limited partnership interest. For example, a partner may own a 1% general partnership interest and a 9% limited partnership interest. This structure does not protect the general partner from personal liability for partnership losses, but does result in the portion of partnership income attributable to the partner's limited partnership interest to be classified as unearned income, not subject to the self-employment tax. As long as the partner is fairly compensated for any services (for example, management services) provided in his or her capacity as a general partner, the IRS should not challenge this arrangement.

      Although it is clear how these provisions apply to general and limited partnerships, it is much less clear how they should be applied to limited liability companies. The proposed regulations under Section 1402 attempt to provide some guidance on this question. As a general rule, the proposed regulations treat an investor in an LLC (or any other type of entity) as a limited partner unless such investor

       has personal liability for the debts of or claims against the LLC by reason of being a partner or member;

       has authority under state law to contract on behalf of the LLC;

       or participates in the LLC's trade or business for more than 500 hours during the entity's taxable year.¹⁵

The proposed regulations establish two exceptions to these rules. First, no individual who is a service partner in a service partnership (including an LLC electing to be taxed as a partnership) can be classified as a limited partner. Therefore, members of LLCs engaged in the practice of health, law, engineering, architecture, accounting, actuarial science, or consulting will generally not be treated as limited partners (and therefore will be subject to SE taxes) unless they provide no services to or on behalf of the LLC.¹⁶

Second, the proposed regulations provide that a member of an LLC can be treated as a limited partner even if he or she participates in the LLC's trade or business for more than 500 hours if

       the member would be treated as a limited partner if not for his or her participation in the LLC's trade or business for more than 500 hours;

       other members who are treated as limited partners own a substantial continuing interest in the LLC; and

       such other members have rights and obligations with respect to their membership interests in the LLC that are identical to those of the

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